“I’m close to going live with my system! It works perfectly!”
– “Great! Have you backtested your system?”
Backtesting. One of those things no trader is really excited about. It usually takes a long time, involves a lot of data crunching and it’s generally, well, boring work.
Yet, it’s the one thing traders can’t live without either! To just say that it’s important for your trading success would be an understatement.
Imagine you’re Elon Musk and you’re building SpaceX rockets. You’ll want to test if they can actually be launched and if they fly as expected, right? Backtesting is that step for trading. It checks if something works as expected.
Or rather, you need to ask yourself the question:
How can I make sure that my strategy has an actual edge?
Reasons For Backtesting Your Strategy
But backtesting is so much more. Checking if your strategy has an edge is, of course, the obvious benefit. But in this article, I want to talk about 4 more reasons why you should backtest. All of these are critical to your trading success and will help you become a better trader. Backtesting is really the ultimate skill.
Let’s get started!
1. Trading Edge Validation
We can’t really discuss backtesting without this one, of course. When you design a trading system, one of the first things you want to know is if it actually has an edge. Does the system you want to trade even work over a big enough sample of trades?
Without going too much into backtesting processes (that’s a topic for a different article), you should at least keep into account the following guidelines:
Objective Strategy Rules
Everything starts with the rules of your strategy. Before you start to backtest, make sure these are as objective and systematic as possible. Instead of saying something like “when I feel the market turns bearish”, try to define what bearish means to you. Is it an engulfing bar? Is it when price crosses a moving average?
Another one could be “when there is a trend retracement”. Again, how do you define a retracement? How do you define if the market is trending to begin with? How deep is the retracement? How fast is it retracing? What do you wat to see before getting in?
By quantifying your rules, there will no ambiguity about executing your strategy when you’re backtesting it. This objectivity will pay off once you start to trade this strategy, because then you’ll have to deal with emotions and trading psychology as well.
With subjective rules, it’s easy to bend the rules to however you see fit for that specific situation. This results in less consistency in execution, which is not what you want. Objective strategy rules allow you to (mostly) execute in a consistent way.
Deciding on a big enough sample size is another important aspect of backtesting. If possible, try to go for at least 50 to 100 trades to see if your edge really works and the result of your backtest isn’t just because of randomness.
Of course, when you’re trading the daily time frame, this means you’ll need to backtest years back to get a representative sample. On the other hand, if you’re a scalper on the 5m charts, you might get enough trades during a 3 month period.
Regardless of the above, try to cover a few different market conditions. For example, the markets would be different around the 2008 financial crisis and you want to test if your strategy still holds up.
If done properly, backtesting your strategy will give you crucial metrics about how your system is performing. What’s the win rate? What’s your average reward to risk ratio? Sharpe ratio? How often does your system give you a signal? Does it perform better during specific time periods? What is the average drawdown like? How about the maximum drawdown during the period you tested?
After defining your trading plan and strategy rules, backtesting should be the first step to take in order to validate if there’s an edge.
2. Process Development
Regardless of the trading strategy you want to use, you need practice trading it. This doesn’t just mean you know the rules of your system, it means that they need to be completely ingrained in your process. Execution of your strategy should come as a second nature, in a way that you hardly need to think about the decisions you need to make. It’s the only way you’ll have the discipline to trade a system live, once that day comes.
But that process doesn’t come automatically. You need to train it. And that’s where backtesting comes into the picture.
Backtesting gives you one thing that live testing doesn’t give you: it shortens the feedback loop between decision making and result evaluation. This means that almost instantly, you’ll see the results of your trading decisions. This is the sort of feedback reinforcement you need to build habits. You’re training the feedback loop.
Next to process, you’ll also strengthen the discipline to trade your system. Discipline and process go hand in hand and if you can nail the execution of your trading system, you’ll see that you can much more easily find the discipline to follow your system. Missteps such as acting outside of your trading plan will become more rare as you go.
If you still have issues following your trading rules with discipline, try this excellent tool by Tom Dante (@Trader_Dante), called Demon Finder. Basically, you keep note of every time you trigger a “demon”. This will underscore the amount of errors you make and will push you towards fixing the demons you have much faster.
3. Strategy Improvement
At some point, you’ll want to go live with your trading strategy. After trading it for a while, you notice something in the past few trades. If you change parameter x, it seems to improve your average R-multiple. But how do you know for sure that this isn’t just a temporary thing?
You need to revisit your backtesting. Run your strategy tests again, this time with the updated parameter, and see how it affects the overall performance metrics of your strategy. This type of measured strategy improvement should be the only way you ever change something about your strategy. It’s the only way you can know for sure that it’s not just a temporary thing but that you’ll benefit from it in the long run.
Rules for changing your rules
- Describe the change and form a hypothesis of why it would work
- Backtest the strategy with updated rules (over the same period of data)
- Validate P/L and observe metrics such as win rate, average win/loss and drawdown closely
- Forward test the new system while simultaneously trading the old system live
- Update your trading plan and implement the new rules on your live account
Of course, you would only move towards the next step if the correct observations have been made and the change actually seems beneficial. It’s also worth noting that changing your strategy so it performs less in terms of equity gain, but also has smaller drawdowns, can be totally acceptable.
4. Confidence Building
Will you keep believing in your system once you get into a longer drawdown?
You should. The worst moment to start doubting your trading strategy is when you’re in a drawdown. You need confidence if you’re planning to trade any strategy long term. That confidence doesn’t come from a couple of trading rules. It doesn’t come from someone else telling you that the strategy definitely works.
It comes with backtesting the strategy and seeing with your own eyes that, given discipline in execution, it will work in the long run. Backtesting is really the only way you can build that confidence and it’s the number one reason traders start to change their trading strategy or worse: they start strategy hopping.
It’s the reason why so many traders fail to adapt a perfectly working system from someone else. Remember this quote from Richard Dennis:
There is no replacement to seeing with your own eyes that your strategy actually works. It’s the biggest confidence builder you can ever imagine and it will guide you through any drawdown you might have.
5. Time Saving
Finally, backtesting is a big time saver. Let’s imagine you’re trading the weekly charts. To validate if a strategy works, you’d need years of forward testing! And how about changing the system parameters? It would be almost impossible to test your strategy without using historical data, but even with shorter-term strategies, the time saving aspect is a considerable benefit.
In one weekend, you can go through years of data. While backtesting will usually still take a long time, it’s nowhere near as time intensive as forward testing would be.
For many different reasons, backtesting is indispensable for any trader who wants to take his/her trading seriously. My backtesting software of choice is definitely Forex Tester 3. Besides actually testing if you can make a profit, it also offers the following benefits:
- It allows you to practice and develop your process and train discipline
- It’s the best way to improve your strategy
- It’s the only way to build confidence in the system you’re trading
- It’s an incredible time-saver
Note: do you want to develop and backtest a trading strategy, but not sure where to start? I have an extensive strategy development and backtesting module in my mentoring program. Let’s talk how I can help you out.
How are you using backtesting? Let me know in the comments!